District Court Addresses Valuation of Minority Interest Stock for Gift Tax Purposes

(Parker Tax Publishing April 2019)

A district court held that minority shares of a closely held company that a couple transferred to their children and grandchildren were properly valued for gift tax purposes by the couple's appraiser by considering comparable companies and taking into account non-operating assets to the extent that those assets contributed to the company's earnings. However, the court found that a transfer restriction to keep the shares within the couple's family should not be taken into account in valuing the transferred shares because the restriction failed to meet the requirements in Code Sec. 2703(b). Kress v. U.S., 2019 PTC 101 (E.D. Wis. 2019).

Background

James and Julie Kress are shareholders in Green Bay Packaging, Inc. (GBP), a family-owned corporation that manufactures corrugated packaging and related products. With 3,400 employees in 14 states, GBP is large enough to be publicly traded but has remained a closely held family company. Approximately 90 percent of its shares are owned by the Kress family and the remaining 10 percent are owned by GBP's employees and directors.

Shares sold by GBP to its employees and directors are priced at 120 percent of their book value. There is no established price for shares transferred to members of the Kress family. GBP's bylaws contain a family transfer restriction providing that family shareholders can transfer their shares only to other members of the Kress family.

James and Julie Kress gifted minority shares of GBP stock to their children and grandchildren in 2006, 2007, and 2008. They filed gift tax returns for those years reporting the fair market value of the gifted shares of $28 per share for 2007, $25.90 for 2008, and $21.60 for 2009. The Kresses paid a total of approximately $2.4 million in gift taxes on the transfers. In 2014, the IRS sent notices of deficiency challenging the Kresses' valuations of the gifted shares. The Kresses paid the deficiencies and interest totaling over $2.2 million, then filed amended returns seeking a refund. After six months of IRS inaction, they sued for the refund in a district court.

Analysis

When the fair market value of stock cannot be determined by examining actual sales within a reasonable time before or after the valuation date, the fair market value is generally determined by analyzing factors that a reasonable buyer and seller would normally consider. The factors include the nature of the business, economic conditions, the company's capacity for earnings and dividends, and the market price of stocks of similar corporations that are publicly traded.

Under Code Sec. 2703(a), stock is generally valued without considering restrictions to sell the stock. However, under Code Sec. 2703(b), a restriction is considered if it (1) is a bona fide business arrangement; (2) is not a device to transfer the stock to members of the decedent's family for less than full consideration; and (3) includes terms comparable to similar arrangements in arms' length transactions.

The Kresses submitted a valuation report prepared by their appraiser, John Emory, which took into account the family transfer restriction. They argued that the restriction should be considered because it met all three requirements in Code Sec. 2703(b). The government disagreed, contending that the restriction was not a bona fide business arrangement because it did not prevent a dissident Kress family shareholder from causing management discontinuity by failing to maintain confidentiality or by starting a competing business. The government also argued that the restriction failed the second requirement of Code Sec. 2703(b). The government said that, although the second requirement specifically refers to transfers to a decedent's family members, the term "decedent" is ambiguous and the statute applies to lifetime transfers as well as to transfers at death.

The district court concluded that Emory provided reliable valuations of the minority owned GBP stock, but it did not accept his discount for lack of marketability because it found that the family restriction failed to meet all three of the requirements in Code Sec. 2703(b). The court said that the family transfer restriction was a bona fide business arrangement because it was included in GBP's bylaws to ensure the Kress family's control over the company and minimize the risk of disruption by a dissident shareholder. The court also found that the restriction was not a device to transfer property to a decedent's family members for less than full consideration. The court rejected the IRS's interpretation that Code Sec. 2703(b)(2) also applies to lifetime transfers and found that Code Sec. 2703(b)(2) applies specifically to transfers at death. However, the court found that the third requirement of Code Sec. 2703(b)(2) was not satisfied because, although the Kresses claimed that restrictions like the GBP family restriction are common, they produced no evidence that unrelated parties dealing at arms' length would agree to such an arrangement as required by Reg. Sec. 25.2703-1(b)(4)(1).

Aside from Emory's application of the discount for lack of marketability, the district court agreed with Emory's valuation methodology. The court found that Emory considered comparable companies and properly took into account GBP's non-operating assets to the extent that those assets contributed to GBP's overall earnings. The court also found that Emory appropriately accounted for the 2008 recession in determining the value of the shares.

The district court rejected the government's valuation because it found that the government's appraiser, Francis Burns, overstated the value of a minority-held share of GBP stock. The court found that Burns' analysis did not adequately account for the 2008 recession and relied on an outlier as a comparable company. The court also found that Burns improperly valued GBP's non-operating assets; in the court's view, a minority shareholder has no control over such assets and could not realize their value until GBP was sold. The court further found that Burns' discount for lack of marketability was too low. The court noted that Burns considered the cost of an initial public offering even though he did not expect GBP to go public. The court also disagreed with the Burns' application of a premium for the fact that GBP was an S corporation because, in the court's view, subchapter S status provides tax advantages but also disadvantages, including limited access to credit markets.

For a discussion of valuing property subject to restrictive arrangements for estate, gift and generation-skipping tax purposes, see Parker Tax ¶223,530.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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